Quick Thoughts: IBM – Yes, We Were Way Too Early

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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July 18, 2017

Quick Thoughts: IBM – Yes, We Were Way Too Early

  • IBM’s 2Q17 sales miss included a sharp deceleration in growth for its cloud businesses, which includes Watson.
  • This deceleration could be anomaly, but could also represent a meaningful erosion in the trajectory of the business. If so, the infection point toward growth for IBM could be further out
  • We believe IBM’s position in the cloud is strong and sustainable, with advantage in serving traditional enterprise as it transitions slowly to the cloud and to AI
  • We maintain IBM in our model portfolio despite this disappointment, as we believe the upside potential outweighs the downside risks to investors.

The story has been the same for 21 quarters. IBM sales are down. Its melting ice cube of a traditional business was off 12%, worse than the 10% decline we were modeling. The one bright spot was the parts of the “Strategic Imperatives” that have nothing to do with the cloud – these high margin businesses were surprisingly up 4%, perhaps helping drive the bottom line beat. Still, we don’t see these businesses as “strategic” and expect them to return to their previously gloomy trajectory in future quarters. IBM’s cloud businesses, the 20% of revenues that we think of as “good IBM”, were 1800bp off our optimistic growth projections. IBM’s public cloud platform grew 31% YoY, which might seem good but not compared to the 59% growth the business had posted just a quarter ago. What happened?

So far, CEO Rometty has offered no real explanation, only reiterating the companies EPS and cash flow guidance for the year. We added IBM to the model portfolio in April, believing that the growth of the good IBM could offset the declining legacy business as soon as 1Q18 – if so, we would expect the stock to rerate. (http://ssrllc.com/publication/ibm-watson-steak-or-just-sizzle/; http://ssrllc.com/publication/ibm-are-we-there-yet/) Despite the pish-toshing of Watson by analysts, we believe that it is a quality AI hosting environment backed by a deep and impressive roster of scientific talent aimed at a set of vertical industry opportunities unaddressed by any of its machine learning rivals. Of course, while GOOGL and FB work magic on their mountains of well-tagged consumer data, IBM is slogging through a morass of poorly structured 3rd party databases under the eye of an impatient investor community. We believe in Watson – it just may take more time than we considered for the success stories to change the narrative.

There will still be an inflection point for IBM, certainly not now, probably not until next year, and maybe not until 2H18. When it happens, there is a lot of runway to the upside. If there is one heartening thing about the 2Q17 announcement, it is that IBM shares only dropped 3% after hours. Maybe for once, the bad news IS mostly in the stock.

Exh 1: IBM Reported Topline Revenues Adjusted for SSR Cloud Segmentation

Exh 2: YoY Revenue Growth Rates Adjusted for SSR Cloud Segmentation

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